To invest wisely, you need to see through the hype and recognize when published rates of return are unrealistic thanks to hidden fees and costs.
A few weeks ago I took my family to our annual vacation spot – Las Vegas. It’s a place that defies the law of averages. Normal people stay awake 16 hours a day. In Vegas, it’s 20+ hours a day. At home, one bowl of cereal and a banana completes my breakfast. In Vegas my stomach’s capacity expands to fit five plates at the wall-to-wall buffet.
One of the lessons I learned this time is that many gamblers mistake their actual wins and losses with what should have happened based on averages. Take the game of craps. In this game you roll two dice and win or lose depending on what number you bet on and what number shows up on the dice. There’s a symmetrical distribution of possible number combinations of the dice. The number 7 is statistically supposed to show up the most number of times and the 2 and 12 the least number of times.
Let’s say you’re playing, and the sequence is: 7–4–2–7–7–2. In that six number sequence the number 7 showed up triple its average and the number 2 showed up 12 times its average. So all the gamblers betting against the 7 empty their wallets in a hurry. But they’ve made a critical mistake: confusing actual outcomes with average outcomes. This is also a common mistake I see individual investors and financial advisors make. Let’s discuss 3 examples as they relate to your investment portfolio:
Short Term Averages Vary Dramatically From Long Term Averages
The US stock market as represented by the S&P 500 Index from 1926 to 2011 (a period of 86 years) had an average annual return of about 9.8% per year. This is how the media and financial advisors make you believe that you should expect about a 10% annual rate of return. The reality is that this is time dependent. Take a look at the average annual return by decade:
In more than half of the decades your average annual rate of return was less than the long term average, with two decades generating a slight negative return over ten years (the Great Depression in the 1930s and the so called “lost decade” of the 2000s).
An investor in the 1930s probably wanted to throw in the towel only to miss out on the high returns over the next 20 years. Conversely an investor in the 1980s and 1990s mistakenly thought that the “new normal” was annual 20% returns only to be sorely disappointed in the 2000s with the financial collapse.
What makes averages even more deceptive is the fact that stock market returns don’t follow a bell shaped curve, so you’ll have extreme negative and positive events that are not explained by simple mathematical models. For example the highest 12 month return has been +54% and the lowest return -43% in one year.
Portfolio Friction Reduces Average Returns
Take a look at the chart on page 10. Let’s assume that you have $500,000 invested in mutual funds in a taxable brokerage account. If you applied the 10% average annual rate of return to that initial investment, then after 10 years your portfolio grows to about $1.3 million.
But that’s like skating on ice--it assumes that there’s no drag on performance due to costs.
Three big costs include mutual fund expenses, inflation, and taxes. Assuming you pay about 1% annually for fund expenses, lose another 1% to taxes on capital gains and dividends, and inflation averages about 3% per year, then your average annual inflation-adjusted after-tax return drops to 5% annually.
So that $1.3 million portfolio drops to about $800,000. That’s about $500,000 less than what you expect based on the historical average return – no small sum of money.
From a practical perspective it means that you’d have to work 12 years longer to maintain your purchasing power and get you back to $1.3 million. Imagine the extra number of nights, weekends, and holidays you’d have to give up.
Individual Investors Vastly Underperform Market Averages
An independent organization called DALBAR publishes its study of individual investor behavior and how that impacts investment returns. The numbers change some annually but the conclusions are the same.
As of 2011 for the past 20 years individual investors earned about a 3.8% annual rate of return in stocks compared to about 9.1% annual rate of return for the US stock market.
You may think that investors do better with bonds, but the study shows that bond investors got a paltry 1% annual rate of return. That was much worse than annual 7% rate of return on US bonds.
What makes this so much worse is that it doesn’t even account for the eroding effect of taxes and inflation on your investment portfolio as I discussed above.
The study found two potential reasons why investor performance was so abysmal:
- Investors tend to guess wrong especially when the stock market goes down
- Investors tend to hold their investments for only a few years
So remember that anytime you look at average annual returns of any investment, that average assumes that you stay in the market and don’t bail out no matter what happens. It doesn’t account for the irrational behavior many of you have when it comes to investing.
How many of you stuck it out in 2008? How many of you had the guts to buy more stocks in 2008? C’mon be honest. If you’re a mid or late career physician and you pulled this off, then you’d be semi or fully retired by now with the subsequent 100%+ rate of return since then.
One key to successful investing is to realize that it’s unlikely you’ll obtain the average rate of return. When you invest with this thought in your mind, you’ll have more realistic understanding of where you’re heading and how to get there.
Setu Mazumdar, MD, CFP® practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com